Add or Drop Product Line
Add or drop product line is the method which the company uses to evaluate the performance of product line (segment) before droping underperform product and focus on the best performing one. Most of the companies are highly likely to drop any product or segment which is not making any profit for the company. That is good to analyze all products that are making a loss, but it does not mean that we need to stop production of all of them. The products may not have profit, but they generate sales which enables the company to cover the fixed expense. However, if the product sale is less than its variable cost, there is no point to keep producing it.
We need to prepare a proper report of each product revenue and cost, this information must be separate base on the actual situation.
Example
Company A has three product lines, X, Y, and Z. The performance of all products can be seen below:
| Item | X | Y | Z | Total |
| Sale | 100,000 | 70,000 | 130,000 | 300,000 |
| Variable Cost | (60,000) | (50,000) | (60,000) | (170,000) |
| Fixed Cost | (20,000) | (30,000) | (40,000) | (90,000) |
| Net Income | 20,000 | (10,000) | 30,000 | 40,000 |
The company considers to stop production of product Y which is making lose around $ 10,000 every month.
As the cost accountant, please advise the company if they should drop produce Y.
Solution
By dropping product Y, we will lose both revenue and variable cost from this product. However, we still need to pay for the fixed cost which is unavoidable. Even the product Y is making losses, but it still generates contribution $ 20,000 (Sale less variable cost) which will help to cover the fixed cost $ 30,000. Without product Y, the company will lose $ 30,000 due to the fixed cost.
To be clear, we will prepare total report as the comparison below:
| With Y | Without Y | |
|---|---|---|
| Sale | 300,000 | 230,000 |
| Variable Cost | (170,000) | (120,000) |
| Fixed Cost | (90,000) | (90,000) |
| Net Income | 40,000 | 20,000 |
As we can see, If we stop the production of Y, the whole company will decrease its profit $ 20,000 ($ 40,000 less $ 20,000). We loss sale of $ 70,000 and variable $ 50,000 but we need to pay fixed cost of $ 30,000. Even product Y does not make any profit, but it helps to pay off $ 20,000 of fixed cost.